Financial Downturns = Opportunities?

I think I don't have to talk much about the recent (or rather, an issue that has been brewing for more than 1 year) financial meltdown at Wallstreet given the great publicity and tremendous amount of news pouring in every day every hour every minute. 'Too big to fail' is no longer a guarantee when you see giants like Merrill, Lehman, Fannie Mae & Freddic Mac all going down. Morgan and Goldman were also compelled to turn to depository capital thereby ending the era of Investment Banking Giants as the standalone model gets questioned.

Just when Warren Buffet fans can still recall the guru saying that he won't touch IBs as they are overpriced, the news today scream "Buffet to Invest $5 billion in Goldman".

So what do you think about the US government pumping in more than US$700 bn into the money market and the curb down on short selling? Firstly, where does the US Government gets that much money? From taxpayers of course. And probably by printing more money (since the supposedly independent Fed is now a 'lackey' of the government) as well, you never know. And while all that liquidity pumped in may calm the market, it did not solve the problem at all.

The crisis starts from those institutions in taking in too much risk, a typical Moral Hazard. Whether or not Morgan or Goldman is a pure IB or now a bank holding does little, if not, nothing to solve the root problem. If one is greedy, and wants to take in more risk at the expense of others, you can do so anywhere. The institution does not matters. Even worse, should the management be as short sighted as Merrill or Lehman, more people's hard earned deposits will be at risk. Sure, some will argue that as bank holdings, these institutions are now regulated. But with all the hoo haa of the subprime crisis, few can still remember how a bank in UK almost failed due to the subprime as well. If you have forgot about this, please google "Northern Rock". And should such an episode play out again with the IBs replaced as banks, you get a magnitude of bank runs that will be more entangled with the people's lives and economy resulting in even worse consequences.

And with more money pumped into the money market system, one can expect inflation to come. Higher inflation to justify lower unemployment rate, back to the older styled Phillips curve. Should inflation spirals faster than expected, expect a very reactive interest rate cut.

On the topic of short selling, I have mixed thoughts about it. Sure, it did boost confidence into the capital markets. After all, the market is oiled by confidence. Without this, everything does not run anymore. And I am happy to present you a view by someone in the hedge fund research industry where I had interned:

Anyway, i disagree it is a necessary step.  Short-selling is not the
cause of the problem, it is a reaction.  Also, people are just
bunching the different types of short selling together and saying
it's wrong.  I think naked short-selling is detrimental because there
is a potential supply-demand mismatch but covered short selling is
perfectly fine.

In times of stress, the short sellers are actually the providers of
liquidity because the people who actually own the shares are loathe
to sell since it means monetizing losses. And by banning short
selling now, all the regulators have done is move people who want to
short to using derivatives such as swaps and structured notes. So,
they still have not resolved the issue of short-selling, but only
push it to a different part of the financial system.  And worse, at
least short selling is regulated as it needs to go through the
exchange so there is a clearing house.  But shorting via derivatives
is not.

Next, there are also a lot of strategies that have a valid reason to
short eg all the relative value, arbitrage strategies. They are not
shorting to make a firm go bust, they are shorting to hedge out an
undesirable exposure in their portfolio.  There is no evidence to say
that short-sellers caused the demise of the market.  A market comes
down because no one wants to buy in the first place so selling (in
any form) will push the price down.  Short-selling is just an easy
scapegoat because most people don't understand how it works and there
is no clarity on that aspect of the market.  In the past year, it has
been relatively difficult to short-sell because brokers are charging
very high costs of borrow so in fact, shorting of stocks amongst
hedge funds has really not been that prevalent (at least in the funds
in the emerging markets). Most have preferred to use cash or buy put
options and others will short index futures.

And finally, if short-selling really was the main culprit for the
mess, that means there needed to have been massive amounts of short-
selling in the system in order for the prices to be pushed down to
these levels, then someone or some group of people must be making
bucketloads of money. The people who are most likely to use shorts
are bank prop desks and hedge funds.  Banks are going bankrupt so
they're definitely not short-selling.  Most hedge funds are in the
red for the year and the ones who are positive total around 10 -20
funds of which a number are trading credit, commodities and futures
rather than outright equity. So, I have not been able to find any
beneficiaries from these mythical volumes of short-selling, then is
short-selling really as big as the papers make it out be? I think it
is just simple dumping of stock due to lack of confidence that is the
real problem.

Another anecdote, I was talking to a guy at Goldman Sachs who covers
the pension funds. The pension funds are cash rich and they all agree
that the markets are cheap now but they don't want to buy anything
because they don't trust the brokers and the custodian banks. This is
a full-blown confidence crisis on the mechanisms of trade rather than
problems with the trades themselves.

It does pay to never rely fully on the news that was reported even in the US press:)